When Will Interest Rates Head Up?

The question on just about every bond investor's mind is simply this: When will interest rates rise? With rates on most types of debt near record lows, it seems that rates have nowhere to go but up. That would send bond prices down. And with yields at such depressed levels, the amount that investors stand to lose from a jump in rates has grown (the lower a bond's yield falls, the more it will lose in price from a rise in rates).

The Federal Reserve, under chairman Ben Bernanke, is holding rates down two ways. It is keeping short-term rates near zero by targeting the federal funds rate, the rate at which banks lend money to one another overnight. And it is holding down long-term rates through monthly purchases of $85 billion worth of Treasuries and mortgage-backed securities. The Fed's actions have driven investors to look further afield for income, which has in turn pushed down rates on everything from junk bonds to municipal bonds.

It's impossible to say where rates would be now in the absence of Fed manipulation. Over the past 50 years, the benchmark ten-year Treasury bond has yielded an average of 2.5 percentage points more than the inflation rate. Interest rates on Treasury inflation-protected securities show that investors expect consumer prices to rise an average of 2.5% a year over the next decade, suggesting that the ten-year Treasury, which yielded 1.7% in early April, should yield about 5%.

Thankfully, rates won't be rising to 5% tomorrow (or this year, or likely even next year). The Fed has consistently signaled that it plans not to raise rates until the economy improves significantly. Bernanke recently reaffirmed that the central bank won’t increase short-term rates before the jobless rate drops to 6.5% (it is currently 7.7%) or inflation expectations rise to greater than 2.5%.

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And although Bernanke has said the Fed will stop its long-term bond purchases before it raises short-term rates (which could cause long-term yields to rise even as short-term rates stay put), the end of its bond-buying spree could still be years away. In a late-March press conference, Bernanke noted that the Fed's bond purchases seem to be helping the economy and have done so without creating any major risks so far. Moreover, the Fed has signaled that it will vary or taper its purchases before it ends them outright. All of this suggests that the Fed isn't seriously considering allowing long-term rates to rise yet, and that any rise may be slow in coming. (Kiplinger's expects the yield on ten-year Treasuries to tick up to 2.25% by the end of 2013.)

Timing will be tricky. Investors hoping to bail out of bonds before interest rates start rising in earnest will have a difficult task in getting their timing right because of the slow-moving nature of the economic improvement that the Fed awaits. “Most of the factors that drive U.S. interest rates are long in nature and slow in coming,” says Guy LeBas, chief fixed-income strategist for brokerage firm Janney Montgomery Scott. Your best approach may simply be to watch the Fed itself for signs that it is winding down its bond-buying program.

Eventually, rising rates will drive losses -- albeit not catastrophic losses -- for many bond funds. (If you hold individual bonds until maturity, you'll get back your principal, assuming the issuer doesn't fail.) But eventually could prove a long time to wait in safe short-term investments that yield nothing. If you want more income today, you'll have to assume the risks that accompany the kinds of investments we describe in this month's cover story.